Decision- Making (part 1) Flashcards
Rational choice
Expected Value (EV)
Represents the average outcome if a scenario is repeated multiple times.
Calculated using probabilities and the values of possible outcomes.
Example: A gamble
75% chance of winning $200
25% chance of winning $0
EV = (0.75 × $200) + (0.25 × $0) = $150
Advantages for using expected value.
Clear prescription for “correct” choices
- Leads people, on average, to maximize monetary
gains given what they know about the world
- Keeps people’s decisions internally consistent
Problems with using expected value:
Difficult to apply for non-monetary decisions
* Doesn’t explain actual choices by actual people!
Behavioral economics
Prospect Theory (Kahneman & Tversky, 1979)
People do not base decisions solely on expected values, probabilities, or absolute outcomes.
Instead, decisions are influenced by:
Subjective utility – Personal perception of value rather than actual value.
Decision weights – Overestimating small probabilities and underestimating large probabilities.
Relative outcomes – Evaluating gains and losses relative to a reference point rather than absolute wealth.
Subjective Utility
Diminishing Marginal Utility
Subjective utility increases at a slower rate than objective value, especially for large amounts.
Example:
$10 feels roughly twice as valuable as $5.
However, $10,000,000 does not feel twice as valuable as $5,000,000.
Individual Differences
The impact of money varies depending on personal wealth.
Example: $1,000 means more to an average person than to Bill Gates
Subjective Utility/Loss Aversion
People convert objective value into subjective utility (personal perception of value).
Utility = The perceived usefulness or desirability of an outcome.
Loss Aversion
Losses feel more significant than equivalent gains.
Example: Losing $20 feels worse than winning $20 feels good.
Individual Differences
Sensitivity to loss varies among individuals.
Some people are more risk-averse, while others are more willing to take risks despite potential losses.
Subjective Utility Function
A subjective utility function represents how individuals perceive and assign value to outcomes, rather than relying on their objective numerical value. It is a key concept in behavioral economics and prospect theory, explaining why people make decisions that deviate from purely rational calculations based on expected value
Decision weight
People transform objective
probability into subjective decision
weights
- Small probabilities (but greater
than 0%) are overweighted - 1% feels like much more than 0%
- 51% feels about the same as 50%
- Large probabilities (but less than
100%) are underweighted - 99% feels like a lot less than 100%
- 50% feels about the same as 51%
Reference dependence( framing effect)
People make decisions based on perceived gains and losses relative to a reference point, rather than absolute outcomes.
The way a choice is presented (framed) influences decision-making, even if the actual outcomes remain the same.
Prospect Theory Summary
Utility & Loss Aversion:
Gains lose value with more wealth (diminishing utility).
Losses hurt more than gains feel good (loss aversion).
Decision Weights:
Small probabilities are overestimated, large ones are underestimated.
Framing & Reference Dependence:
Decisions depend on reference points.
How a choice is framed (gain vs. loss) affects decisions
Prospect Theory
is a behavioral economics theory developed by Kahneman and Tversky. It describes how people make decisions involving risk and uncertainty, showing that people don’t always act rationally
